Question

3. You are considering opening a new plant. The plant will cost $100 million upfront. After that, it is expected to produce profits of $30 million at the end of every year. The cash flows are expected to last forever. Calculate the NPV of this investment opportunity if your cost of capital is 8%. Should you make the investment? Calculate the IRR and use it to determine the maximum deviation allowable in the cost of capital estimate to leave the decision unchanged.

If we calculate the NPV of this investment opportunity, we come up with a positive value of:

NPV = -$100M + ($30M/8%) = $275M

The NPV rule indicates that by making the investment, the value of the firm will increase by $275 million today, so we should make the investment.

Can you please show me how to calculate the IRR?

Answer 1

Calculation of IRR is done using excel. otherwise the only other method is through trial and error.

IRR is the cost of capital at which NPV = 0. So, using Goal seek in excel,

IRR of the project is 30% using Goal Seek function in excel. To have a more exact figure, Solver function in excel can also be used.

As NPV is positive and IRR> Cost of capital ie 8%, the investment can be made.

Formulae